Insolvent Thinking

It is possible neither Janet Yellen nor another pretender will fill Bernanke's
shoes in January. The odds of such a surprise may be once-in-a-history-of-the-universe,
but those keep coming at a faster rate the longer we splurge. Simple Ben has
been walking both his bank and the world's financial institutions closer to
the cliff. Here, we will look at the precarious position of the Federal Reserve
and the far-out financial securities entering the pipeline at an increasing
rate.

The machinery of state demands exponential buying by banks, insurance companies,
and pension funds. The purchasers risk insolvency by doing so. Chairman Bernanke
would be the last to recognize this problem, unaware as he remains of his own
institution's balance-sheet woes, and not understanding the financial calamity
in 2007.

Central banking insolvency does not matter at the moment. The Emperor's
New Clothes is preferred by Wall Street and the media alike.

The Federal Reserve's balance sheet is a mystery, but not that much
of a mystery. John Hussman wrote in his November 4, 2013, letter to clients
in ("Leash the Dogma"): "A
brief update on the bloated condition of the Federal Reserve's balance sheet.
At present, the Fed holds $3.84 trillion in assets, with capital of
just $54.86 billion, putting the Fed at 70-to-1 leverage against
its stated capital. Given the relatively long maturity of Fed asset holdings,
even a 20 basis point increase in interest rates effectively wipes out the
Fed's capital. With the present 10-year Treasury yield already above the weighted
average yield at which the Fed established its holdings, this is not a negligible
consideration."

The 10-year yield has risen from 1.40% on July 27, 2012, to 2.6% or so today.
Thus, the Fed is insolvent six times over. Life goes on.

There have been no sightings of central bankers jumping from windows yet.
Of course, it's not their money; it isn't money at all, so we pretend. Since
the Fed governors are academics, their financial knowledge is wanting. A practical
reason for reducing quantitative easing (q.e.); actually, a practical reason
for never getting started; is the reduction in top-rung collateral. Banks and
other financial outfits borrow and lend in the trillions every day. Treasury
securities that have disappeared onto the Fed's balance sheet are no longer
available for collateral.

The Fed can lower standards of collateral. It has in the past, but it cannot
make a bank accept Bit Coin receivables. This was central to the insolvency
of Bear Stearns and onward in 2008. J.P. Morgan and Goldman Sachs were not
going to repo (lend overnight) with an institution that might be shut the next
morning.

This sinkhole of miscalculations was up for discussion on October 18, 2008,
when the Wall Street Journal published an interview with Anna Schwartz.
The article opened: "On Aug. 9, 2007, central banks around the world first
intervened to stanch what has become a massive credit crunch. Since then [note:
over one year later - FJS], the Federal Reserve and the Treasury have taken
a series of increasingly drastic emergency actions to get lending flowing again.
The central bank has lent out hundreds of billions of dollars, accepted
collateral that in the past it would never have touched, and opened
direct lending to institutions that have never had that privilege. [The
Fed will do anything, so watch your wallet. - FJS] The Treasury has deployed
billions more. And yet, 'Nothing,' Anna Schwartz says, 'seems to have quieted
the fears of either the investors in the securities markets or the lenders
and would-be borrowers in the credit market.'"

Anna Schwartz was co-author with Milton Freidman of A Monetary History
of the United States, 1867-1960. She went on to tell the Journal: "[T]he
Fed has gone about as if the problem is a shortage of liquidity. That is
not the basic problem. The basic problem for the markets is [uncertainty]
that the balance sheets of financial firms are credible." This was true although
Simple Ben and aligned interests still refer to the "liquidity crisis," not
the "insolvencies" in 2007 and 2008. The title of the Journal's interview
was "Bernanke is Fighting the Last War."

And now, Fed Chairman Bernanke has led the Fed itself into insolvency. You
can be sure there have been high level meetings at the largest financial institutions,
pondering what to do if a fellow Too-Big-to-Fail Bank steps away from repo
loans between itself and the Fed.

The Fed has introduced a slew of other problems attributable to its q.e. and
to ZIRP (Zero-Interest Rate Policy). U.S. money-market funds break even by
purchasing lower-rated European bank debt. Reuters, on September 25, 2013,
reported: "Life insurance is becoming an unviable business in Europe as low
interest rates reduce insurers' profits, forcing many to compensate with higher-risk
investments or move overseas, according to an industry survey." A Bloomberg headline
from September 26, 2013: "Pension Funds Need to Buy Higher-Yielding Assets,
Allianz Unit Says." Also from Reuters: "U.K. Pension Funds Take on Leveraged
Loans in Search of Yield."

The longer investors find themselves buying while holding their noses, the
worse are the securities offered. Corruption is one result. The Financial
Times reported on November 10, 2010: "[T]he credit rating agencies are
using 'deluded' processes to calculate the risks of asset-backed securities
(ABS).... 'Here is a situation where you keep putting more untenable risks
into the system,'" declared William Harrington, who "spearheaded analysis on
derivatives between 1999 and 2010 at Moody's Investors Services."

"However," the Financial Times goes on, "institutional investors such
as pension funds and insurers have begun to increase their exposure to ABS
once again, as low interest rates force them to search for alternative sources
for yield."

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.